Over the past few decades, Warren Buffett (Trades, Portfolio) has executed a number of preferred stock and debt deals with Berkshire Hathaway's (BRK.A, Financial) (BRK.B, Financial) equity.
These deals often give Berkshire a set annual percentage return with the option to convert the preferred stock into ordinary shares after a period. Other agreements provide the conglomerate with a fixed interest rate for the amount of money it has lent.
These deals might seem odd in some respects considering the Oracle of Omaha's investment performance. He has made billions of dollars investing in individual securities. Stocks often provide higher returns than bonds or fixed income style securities, so it would make sense that if Buffett really wanted to maximize his return on capital, he would focus on stocks instead of locking up money in fixed income style investments.
However, this would not fit with Buffett's style. While he has made a name for himself investing in common stocks, he only wants deals where he has a good understanding of the underlying business. This severely limits the opportunity set for Buffett and Berkshire.
Fixed income style securities do not require so much research and understanding of the underlying business. Instead of trying to work out a company's brand value and underlying earnings potential, there are only two things a fixed income investor needs to know about a business: whether the return on the offer is attractive and whether the company is going to go bankrupt.
Buffett explained these principles at Berkshire's 2010 annual meeting. Responding to a shareholder who asked the CEO why he decided to lend Harley-Davidson (HOG, Financial) $300 million at a 15% interest rate with debt instruments rather than buying the stock (it went from $12 to $33 over the same time frame), the Oracle of Omaha responded:
"The truth is, I don't know whether Harley-Davidson equity is worth $33 or $20 or $45. I just have no view on that... But I do know, or I thought I knew, and I think I was right, that, A) Harley-Davidson was not going out of business. And that, B) 15% was going to look pretty damned attractive...
I knew enough to lend them money; I didn't know enough to buy the equity. And that's frequently the case. And, you know, we love buying equities, but we love buying the Goldman preferred at 10%...
And obviously, if I think I can make very good money, as we did on Harley-Davidson, with a very simple decision, just a question of, "Are they going to go broke or not?" as opposed to a tougher decision, "Is the motorcycle market going to get diminished significantly? And, you know, are the margins going to get squeezed somewhat?" And all of that. I'll go with a simple decision."
Buffett has one of the most significant investment track records of all time. A considerable portion of his success can be attributed to his mindset when evaluating investments.
The above is a perfect example of the strategy in action. Buffett could have made a lot of money by buying Harley-Davidson shares, but he didn't know enough about the business. Instead, he took a route that he could understand. To him, locking in attractive profits is far more critical than gambling on future potential.
Many investors miss this point. It's easy to kid yourself into thinking you know a lot about a stock after it produces a substantial return on investment. Unfortunately, more often than not, the investment will be a dud. Research shows that less than 10% of the stocks in the S&P 500 produced all of the index's returns in the past 100 years. That suggests investors have a 90% chance of picking the wrong stocks, even among top industry leaders.
Buffett seems to be well aware of this discrepancy and knows how to swing the odds in his favor.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
- Warren Buffett on the Predictable Nature of the Beer Market
- Warren Buffett: Why Investors Need to Be Aware of Stock Option Accounting
- Warren Buffett on the Mindset Required to Be a Good Investor
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